In Sync

In 2007, National Grid was still insisting that acquisition was part of its strategy. Yet, for the past five years, the company had bought nothing since its $3bn dollar acquisition of New York electricity distributor Niagara Mohawk. Then, within a single month, the company bought Rhode Island Gas for almost $600m and KeySpan for $12bn.

"We always had a strategy and the strategy was about doing the right deals," says Lucas. "We didn’t do a deal for years, simply because we couldn’t find the right deal."

The KeySpan purchase had taken 18 months to tie up, not simply with the owners but also with the local regulators. Lucas accepts that some investors had been nervous about increasing National Grid’s US exposure, where it already owned electricity generation and distribution, and gas distribution businesses throughout the northeast, based on the original acquisitions of New England Electric System (NEES) and Eastern Utilities Associates in 2000. The problem was a perceived heavy regulatory burden.

"They didn’t really understand US regulation," says Lucas. The strong National Grid post-deal share price performance demonstrated that, in general, the markets fully approved. There had also been a few raised eyebrows at the closeness of the deals. "Ideally, you’d like to spread these things out but it just isn’t like that. In terms of getting the other side to tango, in terms of getting the valuations right in terms of being able to make the deals fit in your own portfolio, you do not choose the timing of these things."

Lucas reflects on the investor vote of confidence after the KeySpan deal (the share price rose strongly). "What has changed is not our approach. It has been the market. The market has got its head around our approach and, based upon the evidence, is now confident that we can execute mergers and acquisitions well."

UTILITY CHANGES

One challenge prospective buyers face is when a utility changes ownership and all pricing structures are torn up and the process must begin anew. "Certainly, it is hard, it is very hard. You’re talking about many months of face-to-face, detailed negotiations with the likes of the New York Public Service Commission. A lot of people would say that’s just too hard."

He continues. "So, when we buy a US business, we’ve got a reasonable idea of what we can do with it in terms of synergies and improvements. But, it is not like the UK, where you get five years of clarity on pricing. We get around the table with everyone, because you only do friendly deals in the US in our space, not least because of the politics.

"But we don’t know what it will take for the regulator to approve the deal." Nor, indeed, how long the pricing structure will be fixed. KeySpan was a typical example. Two weeks before the deal was announced, Lucas says he and his M&A team were still uncertain of the regulator.

"We didn’t really have a clear idea as to whether we were going to get a regulatory outcome that would allow us to make the sort of money that we needed to make in that acquisition. If we had felt as we reached the end of that completion schedule, that we hadn’t got the right regulatory deal, we would have turned our back and walked away."

According to Lucas, National Grid had already been operating in the same regulatory jurisdiction as KeySpan, so had the advantage of knowing the regulators concerned. "You can talk to them up front. You’ve got to have a fairly good idea from them what they are prepared to wear and what they’re not prepared to wear. But there is a relatively narrow range in which these people are going to settle."

Furthermore, according to Lucas, unlike the UK, US rates deals are backed by good legal precedents that can be challenged in the courts.

A further difference between rates deals in the two countries is that in the US they can span as long as 20 years. With the KeySpan deal, Lucas explains that National Grid was content with a five year agreement.

When the company had first moved into America it had welcomed the 20 and ten-year rates deals that were then on offer because, at the time, investors liked the long-term visibility they gave.

"The thing about long-term deals," says Lucas, "is that if your crystal ball is good, they’re fantastic. They give you a stable revenue profile against which you can plan and optimise. If your crystal ball isn’t so good, for example we underestimated five or six years ago the amount of investment we were going to have to put into our business, then waiting ten years to get essential investment paid for, is not a brilliant economic model."

Thus, with KeySpan, National Grid was happy that the five year rate deal balanced a time period with flexibility. "If we’d got any big component wrong we only had to live with it for five years," he says.

VALUATION JUDGEMENT

There was one US acquisition during National Grid’s ‘fallow’ period, which tends to be overlooked because within two years the company had sold it on. In August 2004, National Grid bought the wireless business of Crown Castle for $1.1bn and combined it with its UK wireless business.

"Wireless is actually very close to what National Grid is all about," says Lucas, "I mean, 24/7 operations, 99.9999% reliability. It’s also about being asset rich and the dull, boring stuff of keeping things going, whether it is lights, broadcasting signals or mobile phone networks. Basically, if they work, people don’t really notice. But, if they stop working, for sure people notice."

The arrival of National Grid’s new CEO, Steve Holliday, at the end of 2006 coincided with a strategic review that concluded that wireless was not a core operation. The Crown Castle assets, along with National Grid Wireless, was sold in January 2008 for £2.5bn to Australia’s Macquarie Bank.

Also disposed of was the electricity connector between Australia and Tasmania because, says Lucas, it offered no opportunity to grow revenues. In each case, a part of the proceeds were returned to investors in a share buy-back programme.

Even if the expansion into wireless networks had originally seemed to be a strategic fit with the existing gas and electricity network, says Lucas: "At some point you have to say, regardless of whether it fits or not, if it just isn’t being properly recognised by investors, we mustn’t be sentimental about this. We must sell it." The assets were sold for two and a half times what National Grid had paid for them in August 2004.

"We took the same decision when we sold half the gas network in the UK. We sold it, depending on what figures you look at, for either 14% or 23% more than asset value. It was not a change of strategy, just a pure, cold valuation judgement."

As the KeySpan deal was falling slowly into place, the decision was made to pre-finance it using a large consortium of 35 banks providing committed facilities. From these, the necessary $7.5bn was raised to complete.

"Both my treasurer and I knew, at the back of our minds, that there could be a credit crunch ahead," recalls Lucas. "I have worked and operated through the Russian default, the Asian credit crisis and the LTCM crisis. We did not agonise for very long about raising the money for KeySpan up front. In my view, not many people would have had either the circumstances or the guts to do that. Circumstances in our case were how many companies can raise $7.5bn dollars of debt and not actually have assets on the other side."

National Grid eschews the concept of lead bankers. Lucas asserts that the covenants granted by the consortium of banks were so wide that, had the bid failed, the committed funds could have been deployed instead into the $3bn-$4bn annual infrastructural investment programme.

In the event, he recalls with clear pleasure that National Grid saved a "ton of money" – between $300m and $500m – when the credit markets dried up at almost the same moment the KeySpan deal was signed.

"We completed KeySpan on the 24th August, which was 15 days after the credit crunch hit. Other deals were falling apart by the dozen."

BUY AND INTEGRATE

National Grid has a five-man team working full-time on merger and acquisitions prospects.

"We create value by sniffing around the world for undervalued assets and getting them cheap. In essence, utilities are regulated, which means they have a disclosure obligation. This provides a massive amount of detail for customers, regulators and potential acquirers."

He continues: "By and large, utilities trade within relatively narrow ranges compared to what goes on in other sectors. The way we create value is by certainly not over paying for a business. That’s why it took five years between one US deal and another. But we actually have a philosophy of doing things with our businesses. We do not buy and hold. We buy and we integrate. We drive out costs. We drive out inefficiencies and we create value this way. It isn’t easy. This is chopping wood each and every day. It’s grinding out value, penny by penny, pound by pound."

Lucas’ view is that far too many companies pay too much for acquisitions and/or do nothing with them.

"National Grid, I think, is a very simple story about investing long-term in essential infrastructure. That infrastructure is essentially focused on gas and electricity. It’s focused on the US and on the UK. There is more than enough growth in those markets to satisfy us and our shareholders for a very long time to come," says Lucas.

New acquisitions, as and when they are made, will be integrated ‘relentlessly’ into the existing National Grid business structure.

Acquiring in continental Europe poses more of a challenge. "Europe is hard because of vested interests," replies Lucas, "The very slow pace of regulatory reports means that we do not believe there is a reasonable prospect of securing a decent acquisition target at the right price. Perhaps more importantly, if we acquired such a target, could we actually make money out of it?

"In the US, every single one of our targets is publicly traded, so they are all technically available. You cannot say that about European utilities. So, I think while we shall be focusing pretty much all of our attention on the US, we will keep half an eye on Europe. But, it won’t be much more than that for some time to come."

What of the acquisitive National Grid itself coming into play? "I’d never say never but I think it’s less realistic now than it was six months ago," says Lucas. "Having said that, when you look at the sector of the market that’s still very buoyant in terms of deals, it’s been the whole infrastructure side, so complacency is ill advised. Frankly, we are not too big to be a target and we’re never complacent about that. We continue to manage the company as aggressively as we can for all sorts of reasons, but mainly because it’s the right thing for our shareholders."